Investing decisions can be made based on simple analysis such as finding a company you like with a product you think will be in demand. The decision might not be based on scouring financial statements, but the reason for picking this type of company over another is still sound. Your underlying prediction is that the company will continue to produce and sell high-demand products, and thus will have cash flowing back into the business. The second—and very important—part of the equation is that the company's management knows where to spend this cash to continue operations. A third assumption is that all of these potential future cash flows are worth more today than the stock's current price.
To place numbers into this idea, we could look at these potential cash flows from the operations and find what they are worth based on their present value. In order to determine the value of a firm, an investor must determine the present value of operating free cash flows. Of course, we need to find the cash flows before we can discount them to the present value.
Free Cash Flow Yield: A Fundamental Indicator
Free Cash Flows
What are free cash flows? Free cash flows refer to the cash a company generates after cash outflows. It helps support the company's operations and maintain its assets. Free cash flow measures profitability. It includes spending on assets but does not include non-cash expenses on the income statement.
This figure is available to all investors, who can use it to determine the overall health and financial well-being of a company. It can also be used by future shareholders or potential lenders to see how a company would be able to pay dividends or its debt and interest payments.
Operating Free Cash Flow
Operating free cash flow (OFCF) is the cash generated by operations, which is attributed to all providers of capital in the firm's capital structure. This includes debt providers as well as equity.
Calculating the OFCF is done by taking earnings before interest and taxes (EBIT) and adjusting for the tax rate, then adding depreciation and taking away capital expenditure, minus the change in working capital and minus changes in other assets. Here is the actual formula:
OFCF=EBIT×(1−T)+D−CAPEX−D×wc−D×awhere:EBIT=earnings before interest and taxesT=tax rateD=depreciationwc=working capitala=any other assets
This is also referred to as the free cash flow to the firm and is calculated in such a way as to reflect the overall cash-generating capabilities of the firm before deducting debt-related interest expenses and non-cash items. Once we have calculated this number, we can calculate the other metrics needed, such as the growth rate.
Calculating the Growth Rate
The growth rate can be difficult to predict and can have a drastic effect on the resulting value of the firm. One way to calculate it is to multiply the return on the invested capital (ROIC) by the retention rate. The retention rate is the percentage of earnings that is held within the company and not paid out as dividends. This is the basic formula:
g=RR×ROICwhere:RR=average retention rate, or (1 - payout ratio)ROIC=EBIT(1−tax)÷total capital
The valuation method is based on the operating cash flows coming in after deducting the capital expenditures, which are the costs of maintaining the asset base. This cash flow is taken before the interest payments to debt holders in order to value the total firm. Only factoring in equity, for example, would provide the growing value to equity holders. Discounting any stream of cash flows requires a discount rate, and in this case, it is the cost of financing projects at the firm. The weighted average cost of capital (WACC) is used for this discount rate. The operating free cash flow is then discounted at this cost of capital rate using three potential growth scenarios—no growth, constant growth, and changing growth rate.
To find the value of the firm, discount the OFCF by the WACC. This discounts the cash flows expected to continue for as long as a reasonable forecasting model exists.
Firm value=OFCFt÷(1+WACC)twhere:OFCF=the operating free cash flows in period tWACC=weighted average cost of capital
In a more mature company, you may find it more appropriate to include a constant growth rate in the calculation. To calculate the value, take the OFCF of next period and discount it at WACC minus the long-term constant growth rate of the OFCF.
Value of the firm=OFCF1÷(k−g)where:OFCF1=operating free cash flowk=discount rate, in this case WACCg=expected growth rate in OFCF
Multiple Growth Periods
Assuming the firm is about to see more than one growth stage, the calculation is a combination of each of these stages. Using the supernormal dividend growth model for the calculation, the analyst needs to predict the higher-than-normal growth and the expected duration of such activity. After this high growth, the firm might be expected to go back into a normal steady growth into perpetuity. To see the resulting calculations, assume a firm has operating free cash flows of $200 million, which is expected to grow at 12% for four years. After four years, it will return to a normal growth rate of 5%. We will assume that the weighted average cost of capital is 10%.
Multi-Growth Periods of Operating Free Cash Flow (in Millions)
|1||OFCF1||$200 x 1.121||$224.00||$203.64|
|2||OFCF 2||$200 x 1.122||$250.88||$207.34|
|3||OFCF 3||$200 x 1.123||$280.99||$211.11|
|4||OFCF 4||$200 x 1.124||$314.70||$214.95|
|5||OFCF 5 …||$314.7 x 1.05||$330.44|
|$330.44 / (0.10 - 0.05)||$6,608.78|
|$6,608.78 / 1.105||$4,103.05|
Table 1: The two stages of the OFCF goes from a high growth rate (12%) for four years followed by a perpetual constant 5% growth from the fifth year on. It is discounted back to the present value and summed up to $5.35 billion dollars.
Both the two-stage dividend discount model (DDM) and FCFE model allow for two distinct phases of growth—an initial finite period where the growth is abnormal, followed by a stable growth period expected to last forever. In order to determine the long-term sustainable growth rate, one would usually assume the rate of growth will equal the long-term forecasted GDP growth. In each case, the cash flow is discounted to the present dollar amount and added together to get a net present value.
Comparing this to the company's current stock price can be a valid way of determining the company's intrinsic value. Recall that we need to subtract the total current value of the firm's debt to get the value of the equity. Then, divide the equity value by common shares outstanding to get the value of equity per share. This value can then be compared to how much the stock is selling for in the market to see if it is overvalued or undervalued.
The Bottom Line
Calculations dealing with the value of a firm will always use unique methods based on the firm being examined. Growth companies may need a two-period method when there is higher growth for a couple of years. In a larger, more mature company you can use a more stable growth technique. It always comes down to determining the value of the free cash flows and discounting them to today.